Prominent figures in the U.S. are warning that the nation's financial markets have been handicapped by post-Enron regulatory overreach. Treasury Secretary Henry Paulson has made addressing the problem a signature political issue. A blue-ribbon committee chaired by former Bush economist Glenn Hubbard has echoed this sentiment, as does a report commissioned by Sen. Charles Schumer of New York and New York City Mayor Michael Bloomberg.

Their key evidence is data suggesting that U.S. stock markets are increasingly unattractive places for companies to list shares. Mr. Hubbard, now dean of Columbia University's business school, says this is the "canary in the coal mine," an early warning of the increasing costs to U.S. companies of raising money, which in turn threatens investment and growth. Their solution: a lighter touch in regulating corporate behavior.

Are the days of the US dollar as the predominant world currency over? Maybe not. As was noted in the research of Menzie Chinn and Jeffrey Frankel cited in my 2005 post, there are many factors that determine which country's monetary assets become the leading international reserve currency. But to the question of what currency will emerge, we are increasingly ticking off items on the list that would make the answer "the euro."

Burdensome regulations that make our financial markets less attractive are at the top of that list, and in the pecking order of things to worry about regarding our global economic position I would advise thinking a lot less about what China is doing to us and a lot more about what we may doing to ourselves.

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I absolutely agree with your point, "I would advise thinking a lot less about what China is doing to us and a lot more about what we may doing to ourselves."
But, who's interest deserve our consideration?
My concern is that we made a monumental mistake when we totally repealed Glass-Steagall without completely rewriting regulations over our financial sector. Honestly, what's a larger threat, whether our markets favor our business interests more than those of another markets, or whether our markets are leading us at warp speed toward our economic armageddon. For just one example, how long will we shut a blind eye to the enormity of our eponentially growing derivatives risk? Our system requires effective checks and balances to power to survive.
I fear we cannot endure the fallout from the unfettered deregulation of our financial sector much longer and the costs are growing daily.
What I argue is obvious, the unanswered question is, who's to argue for the longterm viability of our economy when it was the FED itself (AG) who vigorously lobbied to get us here?

I wonder whether it is really that negative to observe fewer firms listed in the US? I indeed wonder whether firms currently use regulatory arbitrage to avoid the high standard demanded in the US. However, this strategy might not be sustainable. Investors eventually will figure out that lower standards might worsen corporate governance. From a global perspective the most important aspect is whether it will be possible to convince and maybe teach investors that a race to the bottom [of the regulatory stance] will hurt investors. Very sound theoretical arguments can be made that a race to top is more likely than a race to the bottom. However, many investors are rationally ignorant and hence I am not 100 percent sure that the best regulatory framework will win regulatory competition. America offers a good example of the complexity of the matter. Still it is not clear whether the importance of Delaware for corporate law is the outcome of regulatory competition or of a race to the bottom.

I partly agree with Bailey in that we need to keep a sharp eye on derivatives et al. I was for the elimination of Glass-Stegal, and am unsure of how to rewrite regulations. It is always a huge catfight when you do that. I had some experience with that with the rewrite of the CFMA in 2000.

SOX is for sure written wrong. That is generally what happens when government quickly writes regs to counter or appease a populist movement.

Careful thought needs to go into rewrites. The SEC is perhaps the most antique backward looking regulatory agency in world wide finance.

Cox seems to be making progress there-but it is like eroding a mountain.

My thought is that if we try to level playing fields, we will create unlevel playing fields elsewhere. Better to fix the externalities of regulatory arbitrage, because companies are doing it. They are also engaging in tax arbitrage. No way to stop it.

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Will The Euro Overtake The Dollar? The Sequel

The euro has displaced the US dollar as the world’s pre-eminent currency in international bond markets, having outstripped the dollar-denominated market for the second year in a row.

The data consolidate news last month that the value of euro notes in circulation had overtaken the dollar for the first time...

Outstanding euro-denominated debt accounts for 45 per cent of the global market, compared with 37 per cent for the dollar. New issuance last year accounted for 49 per cent of the global total.

That represents a startling turnabout from the pattern seen in recent decades, when the US bond market dwarfed its European rival: as recently as 2002, outstanding euro-denominated issuance represented just 27 per cent of the global pie, compared with 51 per cent for the dollar.

What's up?

The rising role of the euro comes amid growing issuance by debt-laden European governments. However, the main factor is a rise in euro-denominated issuance by companies and financial institutions.

One factor driving this is that European companies are moving away from their traditional reliance on bank loans – and embracing the capital markets to a greater degree.

Another is that the creation of the single currency in 1999 has permitted development of a deeper and more liquid market, consolidated by a growing eurozone.

This has made it more attractive for issuers around the world to raise funds in the euro market. And, more recently, the trend among some Asian and Middle Eastern countries to diversify their assets away from the dollar has further boosted this trend.

Are the days of the US dollar as the predominant world currency over? Maybe not. As was noted in the research of Menzie Chinn and Jeffrey Frankel cited in my 2005 post, there are many factors that determine which country's monetary assets become the leading international reserve currency. But to the question of what currency will emerge, we are increasingly ticking off items on the list that would make the answer "the euro."

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That doesn't mean exactly mean a gangbuster year: The average GDP forecast for the first half of the year is just 2.3 percent -- though the median forecast was higher and not a single one of the 60 respondents was willing to predict negative growth over the first two quarters.

The Economic Cycle Research Institute, an independent forecasting group, said its Weekly Leading Index slipped to 138.5 in the week ending Dec. 22 from 139.7 in the prior week, due to higher interest rates and more jobless claims.

However, annualized growth in the week ended Dec. 22 rose to 3.8 percent from 3.4 percent in the prior period, a reading not reached since last February.

"Given the steady improvement in the WLI, recession is no longer a serious concern," said Lakshman Achuthan, managing director at ECRI.

Ten-year Treasuries and mortgage rates have not gone through the roof. As a result, housing is going to be OK -- and a thousand doomsday forecasts must be put aside.

Nearly alone on the other side of the fence, Nouriel Roubini claims, in a post reviewing his not-too-bad 2006 predictions, that he has not given up on expecting the worst:

... the next few months will show whether my mid-2006 forecast of a US hard landing in 2007 will be proven true or not. Certainly some of my more recent forecasts for financial markets (equities fall, fixed income rally), about Fed easing in 2007, lack of real economy decoupling in the rest of the world are highly conditional on this US hard landing call. I am still of the view that the risks of a hard landing are high.

Indeed, the forecasters in the Journal survey do see some Fed easing in the cards:

The economists surveyed expect year-to-year inflation to decline to 1.7% in May from 2.0% in November. As a result, they expect the Fed to shift its focus from fighting inflation to helping the economy grow, lowering short-term interest rates to 4.75% by the end of 2007 from the current 5.25%.

It looks like the Bank of England may not be done with interest rate hikes. Not with the continued house price increases reported by Reuters...

And there could be more rate hikes from the European Central Bank as well. Reuters reports:

The case for more euro zone rate hikes got a boost from stronger than expected November money supply data on Friday and from comments on Thursday by ECB Governing Council member Yves Mersch, who said rates remain low in historical terms...

Yes. The strong growth outlook will push the ECB to raise its interest rates to 3.75 percent in the first half of the year and by a further 25 basis points later on. As inflationary pressure is still limited, the ECB will refrain from tightening much faster. Risks to this call are, however, a stronger than expected US downturn or a strong appreciation of the euro. In these cases, the ECB might delay a further hike beyond 3.75 percent.

They also predict:

The euro will most likely further gain in value. There is a significant risk that it rises above 1.40 $ in 2007. Two factors are supporting the young currency: With further interest rate hikes by the ECB, investment in the Eurozone will become more attractive. Moreover, the possibility of a rate cut by the US Federal reserve still remains. Finally, there is a risk that central banks in Asia and from OPEC countries continue to diversify their portfolios and buy euros.

For their part, the consensus among WSJ group is that the dollar will stabilize near 1.3 per euro, about where it is today (though Claus Vistesen thinks there has already been enough appreciation and monetary policy to make a "dent" in eurozone growth).

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"Now we'll all wait and see how it is we will be wrong."

Excellent, David! Bravo.

Here's how it is we could be wrong: with long-term rates lower (4.75%) than nominal GDP growth (5.50%), MEW rebounds, sending GDP north of 3.25%. Meanwhile, elevated resource utilization and the sliding dollar make the CPI creep up further. Et voilà! FFR @ 6% (not a forecast, just a -scary- scenario).

Another thought: forecasters don't seem to think the wealth effect from surging equity prices will be important. They might be wrong. People don't own as much stocks as they own house equity, but the 20% or so increase in the indexes this year is a lot more than the 12% or so housing did last year.

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November 29, 2006

And So It Begins?

Last week was significant in that the dollar breached an important barrier, according to traders. Since May, it had been relatively stable within a euro trading range of $1.25-$1.30. Its fall outside this range left investors wondering whether that was simply due to a lack of liquidity around the Thanksgiving holiday or the start of a more sustained slide in the US currency...

An even bigger concern is growing talk of global central banks diversifying their foreign exchange reserves away from the US currency. One factor supporting the dollar has been huge purchases by foreign central banks. Since 2001, global currency reserves have soared from $2,000bn to $4,700bn according to the IMF, with two-thirds of the world's stockpiles held by six countries: China, Japan, Taiwan, South Korea, Russia and Singapore.

Anxieties over reserve diversification have been around for at least six months, with central banks in Russia, Switzerland, Italy and the United Arab Emirates announcing plans to cut the proportion of dollars held in their reserves. A shift by central banks away from dollars would remove a key source of financing for the US deficit...

Fan Gang, director of China's National Economic Research Institute and a member of China's monetary policy committee, saw things differently. He said the real problem the world faced was an overvalued dollar, not only against the renminbi but against all the leading currencies.

His comments come at a time when speculation is increasing that China, which is thought to hold 70 per cent of its foreign currency stockpile in dollars, is considering a fundamental change in its reserve allocation. These concerns were highlighted on Friday when Wu Xiaoling, deputy governor of the People's Bank of China, said Asian foreign exchange reserves were at risk from the dollar's fall.

Just as it seems interest rates in the US may have peaked, they are being increased by the European Central Bank, the Bank of England and the Bank of Japan. The ECB is expected to raise its main rate from 3.25 per cent to 3.5 per cent at its December 7 meeting. The big question is whether Jean-Claude Trichet, ECB president, will signal further increases in 2007.

Here's something to think about. If the move away from the dollar is for real -- with the presumably inevitable result that current account deficits will not continue to support domestic spending in the United States -- the result will almost certainly be higher U.S. interest rates. Here's a position, which I endorse, about what that might mean for monetary policy:

We believe that changes in the federal funds rate should be considered on the basis of where economic forces are taking market interest rates, a perspective stemming from several presumptions about the way our economy works. First, “a balance between the quantity of money demanded and the amount the central bank supplies” requires the federal funds rate to adjust roughly in alignment with changes in real—that is, inflation-adjusted—returns to capital.

In other words, if long-term real interest rates rise, monetary policy becomes more expansionary even if the federal funds rate doesn't change. (This is roughly behind the idea of associating "easy" monetary policy with a steep yield curve, and "tight" policy with a flat yield curve.) That is worth keeping in mind as you read stories like this one:

In another volatile day on the currency markets, the dollar recovered some poise against the euro on Wednesday after an unexpectedly large upward revision to US growth 2.2 per cent in third quarter against an estimated 1.6 per cent and consensus forecasts of a 1.8 per cent rise...

Speaking in New York overnight, Mr Bernanke struck a hawkish tone on US interest rates, saying that inflation in the US remained “uncomfortably high”.

Analysts said that, while it might be something of a surprise that the dollar had failed to derive support from Mr Bernanke’s remarks, he might be in danger of “crying wolf” over US inflationary pressures.

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Hi Dave,

The reason the USD is going down, and didn't respond to Greenspan, oops, i mean Bernanke (!), is the ongoing adjustment in the US property market. This process has only just begun, not in terms of starts, but in terms of housing competions, which are still near highs. Hence, employment in construction is still high, though with starts down, it has flattened out.

This means that the employment effect is coming in 2007. How big will it be? Who knows (I think bad, but i've been wrong many times before!).

But, what we do know is that, ahead of this process, and with the USD near all time lows, a bad outcome could leave the USD without a rudder and send it tumbling. That's a risk that justifies reducing exposure, or as we do it in hedgefund land, selling the USD.

We also know one other thing. The FED will likely take their time to ease. This process should be a good deal slower than after the stock market crash in 2000. That effect was fast and furious, and the FED a bit slow. Unlike today, the U-rate bottomed in April, the month after stocks turned down. And, the first negative emp report was in June that year. Emp growth has slowed, but it is still positive this time.

So, the longer the process takes, the greater the potential for a nastier eventual outcome. The higher rates stay, the bigger the eventual pressure on housing.

That's why, when Bernanke suggests he is still worried about inflation, the USD didn't bounce. A rate hike, or delay in cuts (as I expect), eventually makes the property adjustment worse not better. And, the downside risks to the USD that much higher.

I hope this helps give a glimpse of how some from the speculative side of the FX arena looks at this issue.

I personally disagree with Andres, although I'm no expert in the arena. It looks to me as if cost-push inflation is coming in the next few months, with rising wages and little to no increase in productivity. If this occurs with no intervention from the FED to raise interest rates, the USD will slip and, given enough time, foreign bodies will begin to sell their USD, furthering any economic woes the US would have at that point. Of course, I could be entirely wrong on that.

hahaha, i agree with both of you! Cyrus, it is possible wage inflation will lead to more price inflation.

but, in this case, the outlook for property, and assets in general canget very ugly. higher rates will impinge on property demand at a time of high supply; higher inflation will challenge asset values which are premised on low inflation and low rates. Yikes!

Your case makes the USD look worse, not better.

that's why selling it seems the really good trade, rather than taking a strong view on the outlook for interest rates!

"We believe that changes in the federal funds rate should be considered on the basis of where economic forces are taking market interest rates, a perspective stemming from several presumptions about the way our economy works. First, “a balance between the quantity of money demanded and the amount the central bank supplies” requires the federal funds rate to adjust roughly in alignment with changes in real—that is, inflation-adjusted—returns to capital."

i can clap to this.

it does make some sense to use a moving average or rate of change of the long term yield to at least be a part of the calculation that determines monetary policy.

the bond market is large enough that price/yield manipulation would be difficult to achieve; but something tells me the goldman sachs/hedge funds of the world would still try in order to get access to cheaper capital/liquidity.

Just look at those Texas janitors getting a 50% (f-i-f-t-y) [That's FIVE, ZERO] pay hike after only a month of bargaining and you know wage inflation is more than andres, Ben and GOD-knows-WHO say it is.
Rates will have to rise to contain this tsunami of inflationary wages and we will just have to face the consequences for the housing market. Those dummies who bought ARMs and sub-primes can go back to camping. Cry me a river, this is about keeping the buck from becoming buckshot.
Interesting amount of foreign relations being conducted by US diplomats at the moment --did Condi take a vacation or what? Most notably Bernanke and Paulson off soon to China on a trade mission, or was that a currency mission? a banking mission? Something.

It sure looks like BB's been played like Charlie Brown since the day he signed on. More & more he's looking like a nice guy on a field full of Lucys, unable to apply reason in a world run by rules he doesn't "get".
First, he gets sucker-punched by a dufus cnbc reporter. Then, he takes someone's advice to forget he's always been a straight-shooter, that we all want him to talk gibberish. Then, for some unknown reason he approves an all but toothless credit guidance to his Banks AFTER they publicly confess to absurdly loose lending practices. And now, it's the BEA's turn to pull the football away with a casual oops.
BEA's under Commerce, it's mission is “to foster, promote, and develop the foreign and domestic commerce” of the United States." THEIR job is to help business do more business. Even I know Commerce is just as political as the RNC. So, why is our FED Head "trusting" them, unchecked, to present a credible representation of anything?
On housing, BB has commented that price increases were "driven by fundamentals". He hasn't asked Congress or used his pulpit to call for greater regulatory control over our financial sector, post Glass-Steagall.
He hasn't even cautioned markets not to overread his professed belief that a lot of economic ills can be cured with printing presses. Obviously, the markets are betting big time that Ben will "work" with them.
In a statement last March on the challenges hedge funds present, BB argued that market discipline can work but counterparty risk management is concerning. Concerning? What's the growth rate of credit derivatives? Is anyone reassured because BB's going to China with Hank?
Dave's wonderful Cleveland Fed link ended with a great closing line: "Credibility is the currency of central banks." We ALL trust in the FED to identify and act on the REAL threats to our longterm economic wellbeing. If the scope is now outside FED mandate, we trust it to argue for new regulatory controls. My simple question for BB is, if we can't trust the FED to act for our LONGTERM economic viability, what are our prospects? Personally, I take no solice that BB's going to China with Hank. It's the Administration's & Congress' profligate policies & practices that got us here & it's folly to think there's a win in this for the FED. I just wish BB would learn, the Lucys in his world NEVER change.

Well the U.S.A. has a problem: it needs to maintain offshore confidence in the USD so foreign investors will keep providing the cash to fund the U.S. Federal Government Deficit. In this environment the U.S. can't really afford to ease, even if the U.S. economy is going down the toilet. The external constraint is too great.

It's a very fine tight rope to walk and sooner or later they are gonna trip over.

Bailey asks a question of BB: "if we can't trust the FED to act for our LONGTERM economic viability, what are our prospects?"

My question is similar, but twisted to read: "How can we (why should we?) trust the FED to act for our LONGTERM economic viability?" This I ask because the FED keeps coming up with (and being proud of) documents like the one Dave linked us to above that ask us pretty much to "trust them." After all they "are" the experts, no?

We'll I don't trust physicians, engineers, economists or pretty much any of the too-arrogant professional classes. What I want to know from them is what they intend to do when faced with difficult choices (policy and other) and then be able to make my choices accordingly.

What I read from the afformentioned paper http://www.clevelandfed.org/Annual01/essay.pdf was that "central banks ultimately can deliver more economic growth by abandoning preoccupaiton with output gaps (and the like) in favor of a price-stability rhetoric and a policy orientation that meets this objective with the least interference to the natural, dynamic forces of the econmy."

Good luck when the FED seems incapable of even admitting to asset inflation, let alone admitting any complicity in such. I'm probably in a distinct minority, but I trust the ECB more than I do the FED. Or maybe I just don't know enough about the ECB to not trust their rhetoric or policy either.

I can't help but keep harping that we'd ALL be a LOT better off today had Congress listened to Katharine Abraham instead of AG. Here's a Dean Baker post that makes the point better than I'm capable of doing.http://www.prospect.org/deanbaker/2006/09/the_consumer_price_index_and_l.html
But, on to today. I appeal to the BB because this Administration, Congress AND current Democratic leadership have ALL convinced me the FED's the only thing between us & a disastrous economic meltdown. Recognizing we're a LONG way from FED transparency, I'd love to hear BB read Dave's linked Cleveland Fed piece verbatum to our financial center moguls. In fact, I'd love to hear BB speak to our long-term prospects, any time, any way he chooses.
I can't fathom a way out of the financial hole we've dug for ourselves except to take our medicine & get back to work. A great first step would be for BB to start explaining to the markets why they've made a terrible bet that he's as short-sighted as they are.

The dollar has fallen over the past couple of weeks because foreign central banks and monetary authorities have changed their behaviour. Instead of passively rebalancing their reserve portfolios, like they did all summer, they have indeed stepped up their net sales of dollars against G10 currencies substantially.

This is an annual phenomenon and is unlikely to spell the death of the dollar, as this type of activity generally moderates in the new year.

The notion that the US government will be up the creek if foreign central banks don't want so many dollars is likely to be flawed.

If the dollar is finally allowed to adjust against Asian and oil-exporting reserve accruers, then the current account deficit will shrink and there is unlikely to be the need to attract as much foreign capital to the US.

This has yet to happen, however. Several Asian central banks (notably the MAS in Singapore)intervened very heavily last week.

This, of course, begs the question: if these guys don't like the dollar, then why do they buy so many?

Yes it does beg the question. And I'm sure they are asking themselves the very same thing. In fact the recent (weak) performance of the USD suggests that the Central Banks are not coming up with a very good answer. Why do we like USDs? No idea. So perhaps they stop buying. In fact the Central Banks of the world don't even have to sell current USD denominated holdings to see the USD in serious trouble. That is: in even more trouble.

The Asian crisis and the building up of FX reserves by Foreign Banks which followed promoted the view that the U.S. will always have access to large capital inflows, no matter how bad economic and foreign policy leadership. Now we are testing the validity of that view. Which was based on intellectual laziness and arrogance more than anything else. The U.S. is not immune to the laws of economics and their is no natural reason why the USD should have International Reserve Currency Status. The impact of that change of scenario could be quite dramatic.

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October 29, 2006

Oops! (Yuan Edition)

China's State Administration of Foreign Exchange banned banks operating in the country from trading yuan derivatives in the offshore markets, according to a document issued to lenders.

"Without SAFE's approval, no institutions or individuals on the mainland can participate in outbound renminbi foreign- currency derivatives trading,'' the regulator said in the document dated Oct. 25 obtained by Bloomberg News. "Banks should provide to clients products and services to hedge renminbi currency risks within the business scope allowed by the regulator.'' A SAFE spokesman said he was unaware of the document.

Foreign banks use the offshore forwards market to make bets on the yuan and avoid restrictions placed on onshore trades by the central bank. Domestic banks have been using the offshore market to hedge positions...

The SAFE document referred to "the need to prevent China's economy from exchange-rate risks and facilitate designated banks for foreign-exchange businesses in providing currency-risk- hedging products and services.'' It gave no specific reason for the ban.

Without that "specific reason", interpretations of the ban are necessarily speculative. But the following seems like a reasonable set of possibilities: (a) The yuan peg is under some pressure; (b) The Chinese banking system remains in a precarious state; (c) The Chinese government is as determined as ever to slow the pace of yuan appreciation; (d) All of the above.

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The likely rationale for the ban is to keep Chinese banks from profiting from the arbitrage between onshore(which reflect interest rate differentials) and offshore(which reflect foreigners' speculative demand for CNY) rates, and thus make speculation on CNY appreciation even mroe difficult for foreigners (as local banks won't be there to bid the USD that they sold onshore.) Click on my name for a bit more on the subject.

"China's State Administration of Foreign Exchange banned banks operating in the country from trading yuan derivatives in the offshore markets, according to a document issued to lenders."
...skipping
"Without that "specific reason", interpretations of the ban are necessarily speculative. ..."

4 speculations are provided.

But to me the one that makes the most sense is not and that is the Chinese Central Bankers are preparing the way to allow the Yuan to float, i.e., removing speculators in their midst of the home currency.

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October 03, 2006

Yuan Wildcard

Long-term mortgage rates have dropped in eight of the last nine weeks to hit their lowest level since March.

Aha. A clear signal its time to review the latest evidence that, just maybe, change is a'comin on the dollar/RMB exchange rate. William Polley was all over the story last week, opining that it "certainly does seem reasonable for China to start widening the band" in which the RMB is allowed to trade. Sure enough, on Sunday this was the report from the Financial Times:

China is allowing the market to play an increasing role in setting the exchange rate value of the renminbi, while weakening the influence of a reference basket of currencies, according to Zhou Xiaochuan, central bank governor...

The role of the currency basket was “gradually diminishing” in favour of market supply and demand, Mr Zhou told Caijing, according to advance copies of the magazine’s reports seen by news agencies.

Beijing has not previously given any details of how the exchange rate regime works, but analysts say the currency basket’s influence has always appeared to be minimal and that in practice authorities retain full control over the renminbi’s value. But Mr Zhou’s remarks will be seen as a signal that the central bank remains keen to allow greater moves in exchange rates and to allow the renminbi to climb further against the dollar.

You, of course, have heard this before...

Mr Zhou said Beijing was committed to moving gradually towards a more flexible exchange rate mechanism.

“The regulator has for several months been tightening up its supervision of short-term capital inflows and loosening up capital account controls on outflows as it fights off a wave of speculative funds betting on yuan appreciation.”

Those capital controls have certainly allowed the Chinese government to pursue their slow and easy approach to "a more flexible exchange rate mechanism" with great success. The burden of proof is probably on those who might suggest that they cannot continue on. But should it, by design or circumstance, prove otherwise, how long can those low US interest rates last?

The low (or zero, in China's case) volatity in exchange rates has created an artifically risk-free marketplace for moves such as certain derivative trades and the carry trades.

I think two points need to be made about this. 1) The stability has masked the potential effects of the quantities (see Setser) of reserve buildup required to keep this situation going. Bear in mind that China doesn't care what the level of its current account surplus (and our deficit) is, it's seeking stability. But the cost of the stability has a magnitude, which constantly increases, and the greater that value gets the more massive the result of a loss of control. At some point the value of the cost of stability reaches a point where it de facto undermines the value of the currency in which it's denominated. Where we are on that continuum is a fascinating question. But there are many other unpredictable but potentially devastating events that could happen even before that point is reached. Effects are magnified to the extent other central banks, private interests, and other currency-interested parties hold the dollar in a risk-free environment and find themselves needing to move quickly.

The other point is that China has through its currency and reserve policies to a non-trivial extent globally eliminated market forces and supplanted them with a control economy.

This is a terrible situation (to anyone who believes in market effiencies to improve productivity and global standards of living).

RR -- I'm not sure the low volatility of the exchange rate -- a given in a world with a sustained nominal peg -- means that risk is not being priced in. That risk will be implicitly priced into the real exchange rate.

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September 25, 2006

The End Of Dark Matter?

Exactly how the U.S. has managed to load on so much debt without seeing its net payments rise remains something of a mystery. Even in the second quarter, the U.S., in effect, was paying only a 0.4% annualized interest rate on its net debt. "It's still quite a good deal," says Pierre-Olivier Gourinchas, an economics professor at the University of California, Berkeley.

In a recent paper, Harvard economists Ricardo Hausmann and Federico Sturzenegger went so far as to suggest that the U.S. might not be a net debtor at all. Instead, they surmised, the U.S. might actually have income-producing assets abroad, such as know-how transferred to foreign subsidiaries, that have evaded measurement -- assets they call "dark matter," after a similarly elusive quarry in physics. Mr. Sturzenegger says the latest data haven't changed his view.

Most economists, however, see a more prosaic explanation: Foreigners have been willing to accept a much lower return on relatively safe U.S. investments than U.S. investors have earned on their assets abroad. Take, for example, China, which since 2001 has invested some $250 billion in U.S. Treasury bonds yielding around 5% or less -- part of a strategy to boost its exports by keeping its currency cheap in relation to the dollar.

Well, to be fair to Hausmann and Sturzenegger, that interest rate differential was part of their story. Much of the debate was actually about the meaning of that differential: Is it some inherently superior aspect of the US economy that drives foreigners to pay a premium for our financial assets? Or is it the agenda of, for example, the People's Bank of China, pursuing policies that are more about internal political objectives than market fundamentals?

In any event, the Journal article suggests that, just maybe, we are seeing the beginning of the end:

As interest rates rise, America's debt payments are starting to climb -- so much so that for the first time in at least 90 years, the U.S. is paying noticeably more to its foreign creditors than it receives from its investments abroad. The gap reached $2.5 billion in the second quarter of 2006. In effect, the U.S. made a quarterly debt payment of about $22 for each American household, a turnaround from the $31 in net investment income per household it received a year earlier...

The gap is still small within the context of the $13 trillion American economy. And the trend could reverse if U.S. interest rates decline. But economists say America's emergence as a net payer illustrates an important point: In years to come, a growing share of whatever prosperity the nation achieves probably will be sent abroad in the form of debt-service payments. That means Americans will have to work harder to maintain the same living standards -- or cut back sharply to pay down the debt.

The article contains a lot of comments hinting at a deep instability that seem, to me, a bit over the top:

If the trend persists, it could also raise concerns about the nation's creditworthiness, putting pressure on the U.S. currency. "It's an additional challenge for the dollar," says Jim O'Neill, chief economist at Goldman Sachs in London...

Among economists' biggest concerns, though, is the fast pace at which the U.S. is accumulating new debt. As that leads to larger interest payments, it will make the current-account deficit harder to control -- a vicious cycle that could accelerate if worried foreign investors demand higher interest rates to compensate for the added risk...

"You end up having to pay more and borrow more," says the University of California's Prof. Gourinchas. "Things could get out of hand very quickly."

And this statement just seems wrong:

The size of the nation's debt payments matters because it represents a share of income that American consumers, companies and government won't be able to spend or save. The higher the debt payments, the harder it will be for the U.S. to prosper.

Any rapid change in capital flows could, of course, be disruptive in the short run, but a lot of borrowing by the country means the same thing as it does for you: Accumulated debt doesn't stop you from earning income, it just limits your ability to spend it. Nouriel Roubini puts his finger on what it all really means:

"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini, chairman of Roubini Global Economics. "The longer we wait to adjust our consumption and reduce our debt, the bigger will be the impact on our consumption in the future."

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"Your standard of living is going to be reduced unless you work much harder...."

Doesn't that depend on what we do with the proceeds of all this borrowing? If it is invested productively, then we won't have to reduce our consumption. If it's consumed or invested unproductively we will. That's the same as with any other kind of borrowing. The presumption of all these dark warnings is that we are doing the latter, but I don't see what that's based on.

I agree with Jim. If anything he understates the point. The question boils down to what returns we earn on capital investment here. The tendency for capital deepening to raise labor returns is independent of who owns the capital. And even the net financial return seems likely to rise, despite the rising net tribute paid to foreigners.

Although the other commentators make theoretically correct points, I think they are wrong empirically. Over the past few years, the US capital surplus (i.e., “borrowing”) has mostly been invested in residential real estate, which is not nearly as productive a use as one might hope for. Residential investment won’t do a whole lot to raise labor returns in the future. Moreover, if you compare investment and savings levels (as derived from the national accounts) to historical averages, you would have to say that much of the surplus has been consumed.

On the other hand, we don’t really know the answer to the counterfactual, how much would have been consumed and invested if we hadn’t been borrowing so much. And one could even argue that borrowing for consumption was a reasonable thing to do given expected productivity growth.

"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini,....etc.
"No argument here." ???

I beg to differ, change the word "harder" to "more efficiently" and I might concur, add "Enthusiastically" to that maxim, and I will concur with enthusiasm. Engineers tend to see accountants as puppy dogs, trying to catch their tails, running round in ever decreasing circles till they fall over, panting with a big innocent smile on their face! A 'for instance' as far back as I can remember (pre-1960's) Engineers have scratched their heads in total perplexity at why we put sticky oil in pipes and pump that sticky oil hundreds if not thousands of miles at huge labour. Madness! Engineers would bag the oil into sausages, place each sausage ballel of oil into a magnetic levitation "PIG" and then fly the oil at break neck speed down a much smaller evacuated tube. Deaserts need water, seawater evaporates in the deasert...slightly obvious statement....as the "PIGS" brake at each end of their jourlney, the momentum is converted into electricity...which in turn propells the out-going "PIGS". Oil arrives at a Sea-Port, and Sea-Water arrives at the Oil Well. Sea Water turns to Fresh Clean Potable water and Sea-Salt. which is a highly desireable and marketable commodity on it's own.

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September 11, 2006

More Fuel For The Yuan-Debate Fire...

... which, thanks to Tyler Cowen (here and here), Brad Setser (here and here), and others, was burning pretty hot last week, comes today in the form of the latest report on the Chinese trade surplus. From The Financial Times:

China’s trade surplus reached $95.7bn through the first eight months of the year, soaring to a monthly record of $18.8bn in August, according to customs statistics released on Monday.

The figures for August were the fourth consecutive monthly record this year, well exceeding the $14.6bn reported in July. China’s trade surplus this year is expected to exceed last year’s total of $102bn within weeks.

The soaring Chinese trade surplus though does imply that the scale of capital outflows needed to keep the RMB from rising, should Chine ever liberalize its capital account (which, as Drezner notes, isn’t about to happen), has grown.

Xinhua, Beijing’s official news agency, on Sunday issued rules demanding international counterparts censor news and information distributed in China and barring them from dealing directly with local clients.

The rules, which take effect immediately, mark a dramatic resumption of Xinhua’s efforts to regulate the Chinese operations of rival foreign news agencies tightly...

Sunday’s ban on the distribution of any agency content that “harms China’s national security or honour” or “disturbs the Chinese economy or social order” matches other recent moves by Beijing to tighten media censorship.

Where this will lead is still anyone's guess...

However, it is unclear how forcefully Xinhua will be able to implement its new regime, which is likely to be opposed by domestic banks and other financial institutions as well as by the foreign news agencies themselves.

... but I'm moved to emphasize this passage, from Tyler's original New York Times article:

The yuan should not, as matters stand, float freely with free capital movements. Large quantities of Chinese savings, currently restricted to the domestic currency, would probably flee the country, worsening the serious solvency problems at Chinese banks. The Chinese must first clean up their banking system before they can have free capital markets. Contrary to the conventional wisdom, a market-determined value for the yuan might well be lower than today’s exchange rate, not higher.

Here's a question: What would normally happen to a free-floating currency, unrestrained by pervasive capital controls, in the wake of, to borrow the characterization in the FT headline, moves to "tighten the leash on foreign media"?

A few disjointed observations. The experience in Korea over the past several years leads me to increasingly question my long held standard econ view that a large yuan appreciation would lead to meaningfully slower Chinese export growth and a smaller trade surplus. This has just not happened in Korea despite won appreciation from 1400/$ to 950/$. Korea's exports grew about 14%yoy in H1 06 and its non-oil surplus hit a record high.

HOWEVER, this is not to say Korea has not experienced any adjustment to this appreciation in the real exchange rate. The current account surplus has plunged from $30bn several years ago to about $4bn this year, in large part because of a sharp deterioration in the net services balances. The lesson being that where the economy is very productivie - manufacturing - the excahange rate adjustment has been compensated for via productivity growth, but where the economy is less competitive and productive - in a variety of services - the real appreciation has swung flows powerfully.

I am not saying China should not appreciate. I am merely making the perhaps pedantic point that appreciation may not yield the 'standard' outcome in exports and the trade balance most commentators expect. And from a political economy perspective, that's the point. The Chinese fear yuan appreciation will lead to severe dislocations in the rural agrarian sector in which China is uncompetitive. This is politically important because this is where the bulk of the population resides. This labor is generally less educated and less able to transition into domestic services. So the fear is an even faster pace of rural to urban migration that is socially destablizing (and perhaps provides more fodder for ultra cheap Chinese basic manufactures/exports). Again, I'm not saying this definitively justifies the Chinese position, but it does help one to understand where it comes from.

Finally, i feel the bit about a free capital account is a red herring in the whole yuan debate. First, even the IMF now agrees that free and open capital accounts should be approached very, very cautiously by developing countries. Second, a free capital account is neither a necessary nor sufficient condition for a freely floating currency. Currency regime is a totally separate decision. Hong Kong has a completely free capital account and a very tightly pegged currency. Third, read the emperical findings, hold your breath, have an extra cup of coffee, and look at Japan. Japan had de facto bankrupt banks and ZERO interset rates, but never had a massive, destabilizing flight of deposits from its banking system. The combination of home bias and a government guarantee do wonders to keep a deposit base stable, despite low real interest rates. And remember, something like 80% of China's deposit base is in government owned banks (read, already guaranteed).

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August 24, 2006

Mostly Good Sense...

... from Arthur Laffer, writing in the opinion page of today's Wall Street Journal. First, what could be read as an implicit defense of core inflation measures:

Prices of goods in fixed supply do tend to rise relative to all prices as the global economy accelerates. In the short run, increases in demand for products in relatively fixed supply result in higher prices rather than more output. And, of course, those products that are typically in fixed supply include commodities such as oil, gold, copper and agricultural products. But to confuse an increase in commodity prices with general inflation is a serious mistake...

In my own comments on core inflation I have emphasized the apparent superiority of core measures in forecasting future headline inflation (here and here, for example). But it is also true, as Dr. Laffer implies, that temporary accelerations in inflation generated by fluctuations in particular relative prices are just not all that bothersome, as long as they do not translate into an ongoing increase in the growth rate of prices more generally. Bothersome from the point of view of economic conditions that a central bank can genuinely affect, that is. Increases in the price of oil relative to all other goods and services are certainly costly, but fixing that problem is outside central bankers' sphere of influence.

It is true that it is within the power of monetary policy to lower the level prices on average, thus neutralizing the impact of rising commodity prices on headline inflation rates. But this will not change the fact of those commodity prices rising relative to all other prices, would do nothing alleviate the pain associated with those relative price increases, and may well exacerbate disruptions in the short run if the monetary policy course is excessively tight at precisely the time the commodity-price shocks are themselves tending to weaken the economy.

I do have a few quibbles. Although I always appreciate perspective in discussions of the dollar's value in exchange for foreign currencies...

With today's U.S. global capital surplus (i.e., trade deficit) equaling almost 6% of U.S. GDP -- an all-time high -- it's only natural that with improving economic conditions abroad, global investors would allocate more of their assets to foreign investments. Hence, the decline in the dollar. Over the years we've seen this type of currency move time and again.

... I suspect the emphasis on specific tax policies...

From 1978 to 1985, the foreign exchange value of the dollar doubled in response to the tax cuts and sound money of Ronald Reagan and Paul Volcker; then, from 1985 to 1993, with the end of the Reagan era and George Bush's and Bill Clinton's original tax increases, it halved back to about where it was in 1978; finally, from 1993 through 2002, the dollar once again appreciated back to its former highs because of the great economics of Presidents Bill Clinton and George W. Bush.

... draws things a little too finely. (Did I miss those tax cuts in the last half of the 90s?) I also think that this statement, which opens the article, is too strong:

You'd have to dig pretty far down in the duffle bag of economists to find one who actually believes in the Philips Curve-- the idea that rapid growth causes inflation.

In fact, most economists agree that there is no long-run tradeoff between inflation and output. But the notion of a short-run Phillips curve, with the embedded idea that inflation falls when GDP falls below its potential, is very much the conventional wisdom. (This book, by economist Michael Woodford, is the bible of current orthodoxy, although, like the real Bible, there are probably more people who adhere to its tenants than who have actually read it.)

Still, the unrepentant monetarist in me can't help but applaud this statement:

In truth, rapid growth in conjunction with restrained monetary base growth is a surefire prescription for stable low inflation. The old saw that too much money chasing too few goods results in inflation couldn't be more accurate.

Well said.

UPDATE: In the comment section, Mike Woodford -- yes, that Mike Woodford -- defends Laffer's comment about the Philips curve, noting that economists no longer believe that growth is inflationary per se. Since that is one of Dave's 5 Essential Macroeconomic Truths, I would be hard-pressed to disagree. And, in fact, I did take pains to say "inflation falls when GDP falls below its potential", emphasis added this time. But to me that is pretty much the old Philips curve idea. The main difference between thinking now and thinking back in the day is that our view of "potential" is more sophisticated, drawing as it does on the ideas of real business cycle theory channeled through the Mike's good (and enormously influential) work. But as long as we replace "the idea that rapid growth causes inflation" with "the idea that rapid growth that drives GDP above its potential causes inflation", it seems to me the Philips curve notion survives. If that is what Dr. Laffer had in mind, I retract my statement.

UPDATE: Gabriel Mihalache has more thoughts on the topic. (And to answer Gabriel's question, Lucas' famous "island model" -- in his 1972 JET article "Expectations and the neutrality of money" -- is indeed a Philips curve model.)

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» Ye'Olde Phillips Curve from Economic Investigations
Arthur Laffer made some weird and vague statements in his WSJ.com commentary regarding the quality of economics who still use the Phillips curve: Youd have to dig pretty far down in the duffle bag of economists to find one who actually believes ... [Read More]

Tracked on Aug 25, 2006 4:26:03 PM

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On the other hand from 1978 to 1985 the spread between us bond yields and the average bond yield of Germany, Japan and the UK rose from -0.6 to + 4.85 before returning to negative levels in 1993. From 1993 to 2000 the strong dollar was also accompanied by strongly rising international interest rate spreads. While far from perfect, the swings in interest rate spreads appears to explain the swings in the dollar much better then the factors he claims.

Or to put it another way the dollar did a round trip from 1978 to 1988 but the policies he cites did not do a round trip over that period that coincided with the dollar moves.

On the other hand capacity utilization leads inflation and total inflation leads core inflation.

Laffer is right that few macroeconomists now believe in the doctrine that he refers to as "the Phillips curve" --- the doctrine that high growth as such is inflationary. Growth that is in line with growth in the economy's potential (or "natural rate" of output) is not inflationary. The sense in which the idea of a Phillips curve is still correct is that growth in excess of the natural rate, owing to monetary stimulus, creates incentives to raise prices faster.
But (and this is presumably Laffer's main concern) supply-side measures that increase the natural rate of output are not inflationary. An important virtue of the modern (micro-founded) theory of the Phillips curve is that it shows both the effects of supply-side measures on the economy's natural rate and the way
in which monetary stimulus can lead to output in excess of the natural rate and accordingly to inflation --- one need no longer think only about one of these possibilities or the other.

Mike. Take a look at what the other vowelness economist - knzn - had to say about that paragraph re the Phillips curve. Simply put - Laffer does not know the difference between SHIFTS OF a curve V. SHIFTS ALONG a curve.

bailey -- You kind of caught me on that one. By "unrepentant" I mean that I think money matters, and that it is still throught the provision of liquidity that the central bank moves the price level. The pity is, of course, I have no idea what the mapping from monetary base to inflation looks like these days. I don't repent, but I do regret that my monetarism is these days pretty much a matter of faith.

Oil prices or other commodity prices are not more outside the influence of central banks than other prices. In fact, they are arguably more easily influenced by central bank actions than other prices simply because they are traded on financial markets and thus move easily, whereas most prices of services and finished goods are far more rigid.

This means that commodity prices will be the first to feel the effect from central bank actions and will more fully reflect them.

Sure there are other factors than those from the central bank that affect commodity prices, but that goes for all other prices as well.

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China’s central bank stoked expectations of further renminbi appreciation on Wednesday by saying the exchange rate could play a role in addressing international payments imbalances.

The statement, in the People’s Bank of China’s second quarter monetary report, came a day before China announced a record trade surplus for the third straight month in July, data that would add to the pressure on Beijing to adjust its currency...

The renminbi has risen just 1.66 per cent since Beijing’s 2.1 per cent revaluation last July, in spite of soaring trade surpluses and complaints from the US that the currency is undervalued.

However, the PBoC has recently permitted slightly greater daily volatility in the renminbi-dollar rate and allowed a series of record highs for the currency. This has fuelled predictions it will widen the current 0.3 per cent daily trading band and allow a more rapid appreciation..

It gave no details and the statement falls far short of a commitment to either appreciation or even significantly greater flexibility in the renminbi exchange rate – which the bank repeated should be kept “basically stable at a reasonable balanced level”.

But some analysts said the report supported the view that a consensus was forming among Beijing policymakers behind a stronger, more flexible currency.

How reliant the Bank will be on revaluation versus other policy options remains to be seen. From China Daily:

China will boost imports, loosen controls on outflows of capital and make the yuan more flexible to help curb a record trade surplus and slow the fastest economic growth in a decade, the central bank said...

But the bank said that China cannot rely solely on currency appreciation to balance its external payments.

"As part of a policy package, the exchange rate can play a certain role in adjusting the imbalance in international payments. But the fundamental way to resolve the international payment imbalance should come from expanding domestic demand and lowering the savings rate"...

We will use various monetary tools to reasonably control lending growth and prevent the economy from overheating," the central bank said. "We will speed up the implementation of the policy of boosting domestic spending and adjusting the economic structure to promote the balance of international payments."

The central bank said it will "adjust the bias in the management of foreign exchange which currently encourages foreign-exchange inflows and restricts outflows"...

The government will adjust preferential policies toward foreign companies, speed up the unification of domestic and foreign company corporate income tax rates and regulate policies by local government to attract foreign investment, the central bank said in Wednesday's report.

China's central bank reiterated on Thursday the country's currency, the yuan, will remain "basically stable at a rational and balanced level".

The early move, according to the China Daily article, went in the "wrong" direction...

The yuan fell 0.08 percent to 7.9772 per dollar as of 3:30 p.m. in Shanghai.

... but it's early yet.

CORRECTION: I think I misread that last China Daily passage. The word "fell" here, I believe, applies to yuan needed to obtain one dollar -- so a decline in the exchange rate means that the dollar is depreciating against the Chinese currency. It has definitely depreciated since -- from Bloomberg:

The People's Bank of China fixed the reference rate for yuan trading at 7.9688 against the U.S. dollar today, compared with a close of 7.9772 yesterday on the interbank market, the strongest fixing since the currency was revalued in July 2005.

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